Late Stage Bases

...Here is a question I received today that may relate to many of you:
“I have a question. IBD and O'Neill talk about how breakouts from 4th or late stage bases can be faulty. How do you know that it's in a late stage base. If the stock has been around awhile, isn't it likely to have had a number of uptrends and a number of levelings off?”

Late stage bases always happen with a stock after several years of up-trends. The builder stocks are the prime example right now. Early last year, the education stocks were the example (COCO, CECO, APOL). A forth or fifth stage base does not have to fail, it can be successful but based on O’Neil’s study of past stocks, these late stage bases have a higher probability of failing. In the stock market, the main focus is to lower your risk making me agree with O’Neil when he says to beware of late stage bases. Take a look at the builders and then the three education stocks above. They all had many up-trends and pattern building stages since 2000-2001. I owned a good deal of Corithian College earlier this decade and have vast knowledge about the company and stock but have not looked back at the stock in great detail since the sell. It does not mean that I can’t buy the stock again but it has not crossed my screens so I don’t bother. If COCO started to cross my screens in 2005, I would not hesitate to buy it again if the opportunity presented itself.

Once a late stage base fails and undercuts the previous base, the counting starts from one again and it is no longer qualified as a late stage base. Base counting is a gray area if you follow some examples in O’Neil’s books. The builders are amazing and have been for years (since 2000). I would not be surprised to see them breakout again but they are in late stage bases as clearly seen on the longer term charts. Failure has a greater chance now than it did 3 years ago in this sector. Play with the odds in the market because no one knows what will happen but lowering your risk will always allow you the chance to make greater profits.

Bases can go back several years as was the case with the commercial services/education stocks. You may not be familiar with these stocks as they have not made screens in the past two years but I always talked about these stocks on past forums and articles. I was in love with this sector in 2002, especially when we were still in the bear market. As for builders, take a look at the 5 year chart on bigcharts.com. The site is free with a java chart that will allow you to look at detail with an interactive touch. Looking at a 5-year chart for HOV (K. Hovnanian) which is hitting new highs as we speak, an investor can see the five bases that have formed with the recent base (pattern #5) currently breaking out from a condensed cup shape. Set the chart to the 5-year option with weekly bars. Even using monthly bars, an investor will clearly see at least four bases. You will notice that each base stays above the prior bases which allows the number to creep higher. If a late stage base failed and broke down, the number count would start fresh from one.

This was the case with Corithian Colleges (COCO) and the action that I witnessed in early 2004. The late stage base failed and the stock took a steep dive lower than the previous base, resetting the number to one. Corithian is now building a new base but sits well below the all time high and has not made any recent screen on MSW. Please take a look at this 5-year chart to see how many bases formed and then the stock finally collapsed after a tremendous run. If you do not have access to the charts, I will try to post a case study detailing both HOV and COCO so you can spot a late base breakdown in the future.

Piranha

Never Forget about a Past Trade

We all know that emotions control every decision that an investor makes in any type of money related vehicle. Whether is be the stock market, real estate, art work or antiques, emotions ultimately set the final price on both sides of the transaction. Some investors have greater control over their emotions while other investors are destroyed by their emotional reactions to certain events.

One common occurrence that I have seen many investors make, including myself, is placing a position in a stock at the wrong time. My last article detailed the importance of timing, while this article will concentrate on the importance of staying focused and emotionally stable when things don’t work out as expected. In the past, I would study a stock’s chart, the fundamentals, the general market health and everything else that I felt necessary before placing a large sum of cash behind my beliefs. When things went wrong and I was forced to sell for a small loss, I would drop the stock from my watch lists and remove it from my memory. This was one of the biggest mistakes that I was making during my earlier years of investing. The greatest investors study their mistakes and learn why they were wrong. If you don’t learn from your mistakes, you will continue to repeat them and never move to the next level.

I was usually correct with my analysis on the particular stock but many times I was too early with my entry point during a new up-trend. Months later, I would come across the same stock in my screens but it was now up 25%, 50% or more from my initial buy point and stop loss. I would be frustrated for selling my stock too soon and was getting tired of using rules and missing big winners that I sold for a loss. I knew money could be made in Wall Street by using the law of averages to my advantage and employing strong money management skills but I needed to employ the rules more consistently. I started to practice what I was taught by selling my losers quickly and allowing my stronger stocks to ride their trends. Over time, I was experiencing a few more losers than winners but my stake was growing because these losers were smaller in size than the winners. The words written in the books were true; Jesse Livermore, Gerald Loeb and William O’Neil were all accurate with their lessons about cutting losses quickly.

More importantly, I learned to keep strong stocks on my radar even if I bought too soon and was forced to sell for a loss. My timing was wrong and my ego was shot because I was wrong, so I typically decided to stay away from that specific stock because it had already taken my cash and my pride. Emotionally, I was burned by the stock even though this was not entirely true. Investing is a game of trial and error. It is okay to buy a stock at the wrong time and sell, only to buy it again because they timing may be better. If you cut the losses small and allow winners to grow, the averages will ALWAYS work out, I promise. You must be honest with yourself to allow the averages to work out. You cannot allow a stock to drop past your sell point and you must try to always hold the strongest stocks without selling them during a premature pullback. This all sounds so easy but it is not! If it was so easy, we would all be extremely rich and the stock market would be everyone’s full time job.

I kept using my system of trial and error and started to record every thought and transaction I made. With my revised philosophy in place; I continued to study the stocks that I was forced to sell and tried my best to re-purchase, even at higher prices than my original position if the time was right. Even now I have these issues, the greatest traders of all time always had these issues and every fund manager must decide if the time is right. My latest example, which can relate to almost everyone in the community is Paincare Holdings, a stock that was purchased solely as a “test buy” that I was forced to sell. If things turn around and the general market starts to rally, I would have no problem buying the stock at a higher price than my original position if the opportunity presents itself.

LaBarge is another example, first showing up on the screens at $9.35 but during a down-trending market. The new pivot point and buy area was $14, over 50% higher than the original price but a solid entry point regardless of past gains or prices. Mentally it is always the toughest to buy a stock at a higher price than you were watching it at an earlier date but it can be the most rewarding strategy. Never look at a chart and toss away a candidate because it has moved up 50% or even doubled in recent months, the real move may just be beginning.

The moral of this article is to make you understand that timing may be your only issue when buying stocks so never throw away a possible superstar because you bought too soon. Keep it on your watch list and be prepared to initiate another position, even if it will cost you an extra point or two. If you buy again and it doesn’t work out, re-peat the process, there is always a chance that the stock was not meant to be or your analysis was slightly faulty. In either case, learn what you are doing right and wrong so you can be prepared to use those lessons with the next stock.

Piranha